Capital Gain: What Obama Should Have Said

Misleading question, weak answer

In the April 16 debate between the Democratic presidential
candidates, Charlie Gibson asked Barack Obama a question about
capital gains tax rates that was argumentative and misleading.
That may sound like a criticism of Gibson, but it's not.
Questions of this kind are appropriate as they test the
candidates' ability to respond to arguments frequently offered
against their positions. In this case, Obama wasn't well
prepared (particularly considering the debate was held the day
after tax day), and Hillary Clinton did no better when the ball
shifted to her court.

Gibson began by noting that Obama has indicated an intention
to raise the capital gains tax rate, and reviewed recent
history: the rate fell from 28% to 20% under Bill Clinton in
1997 and fell further to 15% under George W. Bush. Then he said,
"And in each instance, when the rate dropped, revenues from the
tax increased. The government took in more money. And in the
1980s, when the tax was increased to 28 percent, the revenues
went down. So why raise it at all, especially given the fact
that 100 million people in this country own stock and would be
affected?"

That's a good question, one the Democratic nominee is likely
to face in the general election. It will be asked by Republicans
and will appear on the editorial
page of the Wall Street Journal and other newspapers.

After a brief hesitation, Obama began his response as
follows: "Well, Charlie, what I've said is that I would look at
raising the capital gains tax for purposes of fairness. We saw
an article today which showed that the top 50 hedge fund
managers made $29 billion last year -- $29 billion for 50
individuals. And part of what has happened is that those who are
able to work the stock market and amass huge fortunes on capital
gains are paying a lower tax rate than their secretaries. That's
not fair." He went on to talk about the need to reduce the
deficit, completely ignoring the point that tax revenues went up
when the tax rate went down.

Gibson pressed the point: "But history shows that when you
drop the capital gains tax, the revenues go up."

Obama: "Well, that might happen or it might not. It depends
on what's happening on Wall Street and how business is going."
And he went on to mention the housing crisis and take a dig at
what he saw as an inadequate response from John McCain.

Obama seemed to be groping toward a different issue, the
ability of hedge fund managers to structure deals so the bulk of
their profit is taxed at the lower rates reserved for capital
gain. These structures are legal under current law but unfair
because the true nature of the income is compensation, not
capital gain. The profits should be taxed at the higher rates
the rest of us pay on our wages, but a Republican filibuster late last
year blocked legislation that would have closed the loophole. An
increase in the capital gain rate wouldn't eliminate the problem
but it would at least reduce the disparity. That's a side issue
in the debate over whether to raise the tax rate on capital
gains, however.

The question went over to Hillary Clinton, who also proposes
to raise the capital gains rate, and who opined that "we've got
to get back to an economy that works for everyone" and talked
about how good the economy was in the late 1990s (i.e., when a
Clinton was in the White House).

A better response

Obama might better have responded something like this:

Charlie, it may be true that 100 million
Americans own stock, but most stock held by middle class
Americans is in IRA or 401k accounts, where the capital gains
rate doesn't apply. The tax rate matters for stock held outside
these retirement accounts, and most of that stock is owned by
extremely wealthy individuals. The bottom 60% of households own
just 9%, while the top 10% of households own 70%. Over half of
all capital gains go to households with income over $1 million.
That's roughly two-tenths of one percent of the population
getting more than half the benefit of the cut in the tax rate.

Tax revenue went up after these cuts partly
because people anticipated them. Advisors told their clients to
hold off selling anything for a gain until after the tax cut
passed. Then we had a lot of people making these sales and the
result was a boost in revenue, but that's a temporary effect.

Some say these cuts helped spur the economy.
What they overlook is their role in spurring the stock bubble
toward the end of the 1990s and the housing bubble in more
recent years. These bubbles harmed the economy, and the harm was
felt by many people who saw little or no benefit from the cuts
in capital gain rates.

A response along those lines would have better answered the
argument implicit in Gibson's question.

Two sides to the story

Those in favor of a low capital gains tax rate have
reasonable arguments at their disposal. The long-term effect on
the economy may be favorable enough to provide widespread
benefit. To the extent it lifts stock values, a lower rate
provides a benefit even for people who hold shares in retirement
accounts where the rate doesn't apply. Furthermore, in a system
that doesn't index gains for inflation, capital gains would be
overtaxed without some kind of break.

The change in tax revenue that immediately follows a change
in the capital gains rate is a bogus statistic, though. It's
theoretically possible for the lower rate to lift the economy
enough to provide a sustained increase in government revenues,
but you can't make that case by looking at how taxpayers respond
to the change in the short term.

Advocates of lower capital gains rates (and lower corporate
tax rates, and other tax benefits for business) often cite the
statistic that 100 million Americans own stock, implying that
the middle class will receive an ample share of the benefit. Yet
ownership of stock is highly concentrated in the hands of
wealthy individuals, a small fraction of the population. The
vast majority receive little direct benefit, or none at all. To borrow
an analogy from John Kenneth Galbraith, the "100 million"
argument is like justifying the cost of feeding more oats to the
horses by pointing out that some will fall to the ground and be
eaten by sparrows.